Trade-Off and Pecking Order Theories of Debt
85 Pages Posted: 22 Feb 2005 Last revised: 11 Dec 2007
Date Written: December 8, 2007
Taxes, bankruptcy costs, transactions costs, adverse selection, and agency conflicts have all been advocated as major explanations for the corporate use of debt financing. These ideas have often been synthesized into the trade-off theory and the pecking order theory of leverage. These theories and the related evidence are reviewed in this survey. A number of important empirical stylized facts are identified. To understand the evidence, it is important to recognize the differences among private firms, small public firms and large public firms. Private firms seem to use retained earnings and bank debt heavily. Small public firms make active use of equity financing. Large public firms primarily use retained earnings and corporate bonds. The available evidence can be interpreted in several ways. Direct transaction costs and indirect bankruptcy costs appear to play important roles in a firm's choice of debt. The relative importance of the other factors remains open to debate. No currently available model appears capable of simultaneously accounting for all of the stylized facts.
Keywords: Capital structure, leverage, corporate financing, trade-off theory, pecking-order theory
JEL Classification: G32
Suggested Citation: Suggested Citation